Lecture 1 The framework of economics

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Lecture 1The framework of economics

• Introductory Economics for the Treasury
• Dr. Paul Frijters
• http//econrsss.anu.edu.au/frijters

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Contents

• 0. Practical information.
• 1. Economics in a nutshell.
• 2. The philosophy of economics.
• 3. Basic ideas in economics.
• 4. Basic groupings of economists (in the document)

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Preamble the course structure

Lecture 1 core ideas, intuition backbone
document
Lecture 2-6 fleshing out of core ideas into
standard terminology
Guest lectures applying the terminology and ideas
Strategy immediate depth, followed by repetition
and increasing breadth. Thoroughly understanding
the core ideas is key to the rest.
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Our team

• Dr. Paul Frijters (Fellow Research School of
  Social Sciences, ANU)
• Prof. Bob Gregory (RSSS)
• Prof. Bruce Chapman (head RSSS-economics)
• Dr. Deborah-Cobb Clark (RSSS)

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Goals and practical info

• Goal the minimum I would like you to understand
  is the set of core ideas and intuition of
  economics. Please therefore study the document
  sent to you until proficient.
• http//econrsss.anu.edu.au/frijters
• This site has take-home assignments,
  extra-reading documents, a bulletin board to post
  questions, instructions how to send in completed
  assignments, and time-tables.

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House rules

• Please do NOT send general queries by e-mail. Use
  the bulletin board.
• There will be assignments each of the first two
  weeks and after some guest lecture weeks. These
  should not take much time and you are encouraged
  to give short answers.
• Please complete assignments before the following
  Wednesday. Send assignments to treasury_at_coombs.anu
  .edu.au

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Final house rules

• You are asked to read the lecture notes of that
  week, as well as the suggested reading material,
  before the start of the lectures. If you have
  queries you think are crucial and not answered by
  those notes, please send these queries to the
  bulletin board before the relevant lecture so
  that I can incorporate them during the coming
  lecture.

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Economics in a nutshell

• All decision-makers, i.e. individuals, firms,
  households, governments, and even whole blocks of
  nations, want more than that is possible.
• All have infinite needs and only finite
  resources. Deeply aware of this, nearly all
  economists will ask of a policy proposal who
  will benefit and who will lose ?'.

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Economics in a nutshell.

• The main insight of 200 years of economics is
  that we should not underestimate the degree to
  which nearly all decision makers strive to
  increase their material welfare.
• Whilst no economist believes that material
  welfare is the only thing decision makers care
  about, virtually all economists are deeply aware
  of the devastation caused by policies that do not
  take into account that material welfare is a
  powerful motive for all those subject to a policy.

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Economics in a nutshell.

• The economic analysis of a policy proposal often
  boils down to simply asking and answering the
  question Whose material incentives are going to
  change because of this proposal? How will this
  affect the behaviour of those actors explicitly
  stated in the policy proposal and especially of
  those not mentioned ?'.
• It is not from the benevolence of the butcher,
  the brewer, or the baker that we expect our
  dinner, but from their regard to their own
  interest'. (Adam Smith, 1776)

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Economics as moral philosophy

• 250 years ago, economics, psychology, and
  sociology did not yet exist. Their common
  ancestor was utilitarian normative philosophy.
• Basic stance
• what government should care about is the
  combined welfare of all inhabitants
• The role of economists
• To find out what is in the best interests of
  all, and to relay this information to a
  benevolent decision maker.

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Implications

• - economics is implicitly idealistic, i.e. spends
  it time and energy thinking about how to achieve
  the common good.
• - economics is connected to the many other
  disciplines that share this ideal, such as other
  social sciences and the public sector of Western
  nation states.

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Items of debate

• Whose welfare should be maximised?
• - current citizens?
• - future citizens?
• - citizens of other nations?
• - non-humans?
• - the welfare of the least-well-off person
  (liberalism of Rawls), the welfare of the
  aggregate person (classic utilitarianism), or
  something inbetween?

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Difficulties

• - we dont know how many there will be in future
  generations.
• - we dont know what future generations will
  want.
• - its hard to tell what the current generation
  actually wants because the state decides on a
  future which no-one has yet experienced and hence
  people find hard to judge.
• - in the long run, might is right people in
  power decide what happens, not academics.

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And so

• 1. One should not take the philosophical roots of
  economics as a practical plan of action.
• 2. One should take the philosophy of economics as
  a view of the world.

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Relevance

• - the shared goal determines the questions
  economists ask, i.e. when they ask who cares
  they are actually asking what does this have to
  do with overall welfare maximisation.
• - many terms used in this debate permeate normal
  economic conversations (e.g. utility, social
  welfare functions, impossibility theorems,
  preference aggregation, Pareto Efficiency, The
  Social Contract,..).

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Key economic ideas

• 1. Competition (Adam Smith 1776)
• 2. Functioning markets
• 3. Benevolent rule setters
• 4. Homo Economicus (economic man)
• 5. Equilibrium
• 6. Money Circulation
• 7. Creative Destruction

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Private vices \ social outcomes competition

• - In a situation where many want to sell others a
  similar good, each seller is afraid the other
  sellers are going to sell for a lower price than
  they are. This combined fear leads each to reduce
  their price until they hit costs, i.e. the
  invisible hand of the market lets prices move
  towards costs. At these prices, individuals
  specialise into what they are relatively best,
  implying an instantaneous optimal social order
  arising from selfish behaviour.

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Functioning markets

• - Competition works only in a situation where
  there are indeed many sellers.
• - Buyers need to have access to price information
  and to all sellers.
• - Neither buyers or sellers can collude
  (coordinate) to defraud the others.
• - Buyers and sellers do not cheat by theft,
  reneging on contracts, murder, etc.

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Implications

• - voluntary trade leads to specialisation,
  benefiting all trading parties. This is the basis
  of modern international trade agreements.
• - An impartial benevolent rule setter must
  close down all options for cheating. Basis of
  competition policy.

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Benevolent rule setters who?

• - Independent competition boards made up of
  benevolent experts.
• - Courts with impartial benevolent judges.
• - Policy analysts of governments.
• - Those who draw up constitutions.
• - Anyone with great independent power.
• If none of these are actually loyal to the
  overall good state capture, state failure,
  rampant corruption, economic misery.

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Big assumption

• 1. For some reason or another, there is a core
  group (not necessarily a big one) that cares
  sufficiently about the overall good to
  counterbalance materialist motivations at the
  heart of the state system.
• Implication it is this group that economists and
  scientists in general try to talk to, whilst
  fully recognising that this group is not big.

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Homo Economicus

• The argument apart from scientists and the core
  group within the state, the rest is, roughly
  speaking, maximising their materialistic gain. To
  attempt to organise production without appealing
  to these motivations is to invite disaster.

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Context of this idea

• - Early names in economics John Stuart Mill
  (1844) and Stanley Jevons (1872).
• - Its the defining difference between economists
  and psychologists / sociologists.
• - Falls within an old and wide tradition of
  historical materialism, i.e. presuming that much
  superstructure is ultimately determined by
  materialist motivations.

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Examples of this reasoning

• 1. Cultural inhibitions against eating cows in
  India? The standard explanation of the
  economists this prevents people when times are
  bad from eating their productive future capacity.
• 2. Cannibalism in meso-America in pre-Columbian
  times? The standard explanation of the historical
  materialists amongst anthropologists other
  sources of protein were scarce and hence they
  were just being efficient with the available
  stock of protein.
• 3. Constantly changing European rules on the food
  labeling of Australian beef? Standard answer an
  attempt by the European agricultural lobby to
  prevent competition by Australian beef and hence
  a means of preserving income.

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Evidence for this assumption..

• 1. Merely a week after the Russian tsar Peter
  the Great imposed a heavy tax on wearing beards
  in 1698, there was barely a whisker to be seen in
  his vicinity.
• 2. When my local shop wants to sell something
  quickly, it puts it on sale.
• 3. When contemplating the educational choice of
  our children, many of us want them to do
  something they can earn at least a minimal level
  of income with.

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More evidence.

• 4. One the main activities on the internet is the
  use of search engines for the cheapest airline
  tickets.
• 5. Whilst guaranteing a minimum price for wool,
  Australia maintained overproduction in wool in
  the late 80's, early 90's.
• 6. Within six months after introducing a small
  fee for plastic bags at supermarkets in Ireland,
  the volume of plastic bags dropped 90.

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Evidence continued

• 6. When the European nations subsidised their
  farmers by export subsidies, the borders between
  countries saw the phenomenon of trucks laden with
  agricultural produce crossing the same border in
  different directions dozens of times per day,
  simply to claim the same subsidy many times over.
• 7. The display of materialist behaviour all
  around us every day.

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Disclaimer

• Deeper motivations may underlie wealth
  maximisation
• 1. Status considerations.
• 2. A game-playing' motive.
• 3. To sit on ones wealth and feel big.
• 4. To consume alone and meet basic needs.
• 5. A moral conviction to hoard wealth.
• 6. In order to share around more.

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Disclaimer continued

• For the economist, the underlying psychological
  motivations are of little interest it does not
  truly matter why material motivations are so
  important as long as it is reasonable to assume
  that they are strong and immutable.

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Immutability of materialism

• The appeal to ideological motivation alone can
  work for a limited period of time (e.g. in crisis
  situations), but not for extended periods.
• Main empirical evidence
• 1. Experience with socialism
• 2. Experience with rules that allows mass abuse,
  such as tax loop-holes, disability benefit
  schemes in the Netherlands, some farming
  subsidies

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Experience with socialism

• Lenin and the other socialist economic thinkers
  thought it was possible to replace selfish
  material interests by a shared common goal.
• Braguinsky and Yavlinsky (2000) give a
  fascinating insight of the slide of the Soviet
  State into a chaos of self-interests at the top.

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Main observations on socialism

• - A self-enriching nomenklatura of party bosses
  and factory bosses defrauding the rest.
• - Widespread apathy amongst workers leading to
  general economic stagnation.
• - New opportunities were not recognised or taken.
• - Same experience in other socialist or
  ideological experiments (North-Korea, Tanzania,
  the Kibbutz in Israel, command economies in
  general).

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Equilibrium (Leon Walras)

• An economic system is said to be in equilibrium
  when it is not possible for anyone to improve on
  their outcome by changing their current
  behaviour.
• With full information, full contracting
  possibilities and rationality, a system should
  always be moving towards this point even if it
  never reaches it.

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Arguments in favour

• Introspection would any of us refuse an
  opportunity for improvement if we saw one?
• Do we try to predict and control our environment
  to our advantage?
• Surely yes.

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Examples of rationality

• 1. Individuals save from their current income in
  order to have more consumption later. Such
  decisions are explicitly forward-looking.
• 2. Individuals and households invest in future
  income streams by their education decisions. To a
  large extend, the education paths that we expect
  to lead to high incomes indeed do so.

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• 3.Business confidence indicators are an important
  predictor of future movements in the economy.
  Hence the businesses surveyed on their confidence
  about the future do indeed consciously deliberate
  the future and form meaningful expectations.

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.

• 4. In traffic, we correctly expect others to
  roughly follow general traffic rules. We indeed
  trust our lives to that expectation daily.
• 5. Stock market traders spend virtually all their
  time gathering and interpreting new information.
• 6. Months before the 2004 election, the election
  markets already gave Howard an 80 chance of
  winning the Australian election.

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Disclaimer

• No economist believes that individuals from an
  early age perfectly predict every little event
  that might occur in their whole lifetime.
• They do assume that individuals constantly do
  their very best to anticipate events that are
  important to them, and that their guesses are on
  average right.

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Implication

• 1. Government policy changes the set of
  opportunities for individuals and hence their
  behaviour.
• 2. Non-credible policies are not believed or
  adhered to.
• 3. People anticipate future changes in
  legislation.

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Money circulation (Stanley Fisher)
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Money and inflation

• Main functions of money
• 1. Allows anonymous trade in small quantities
  with little transaction costs allows
  specialisation.
• 2. A store of value allows for pensions.
• Bottom line money allows cheap trade of the
  result of time investments with other individuals
  and with oneself.

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Effect of printing more money

• 1. Inflation more money for the same amount of
  goods increases the number of notes per good.
• 2. (much worse) Unexpected hyper-inflation. This
  wipes out the value of savings and leads to
  fluctuations in relative prices, undermining
  specialisation.
• 3. Eventual loss of confidence in money leading
  to alternative means of exchange and reduced
  specialisation.

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Hyper-inflation

• - Experienced by Germany in the 1930s, France in
  the 17th century, various countries in
  Latin-America after the 1960s.
• - Initial reaction of the economy to money
  printing is to grow and then to spectacularly
  crash.

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Creative destruction

• Names Joseph Schumpeter, Friedrich Hayek and
  Ludwig von Mises (1930's through till 1980's).
• Key idea A continuous stream of shocks and
  discoveries constantly creates new opportunities
  and closes down old opportunities.

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What kind of shocks?

• 1. A manager faced with the fact that 20 of his
  old staff has retired or taken maternity leave,
  needs to attract new workers and re-arrange
  workers to tasks in order to maintain output.
• 2. A manager faced with workers who age and
  change in personality must likewise re-arrange
  persons over tasks.

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• 3. An organisation faced with new technological
  possibilities must similarly somehow attain the
  expertise of incorporating the new technology,
  ditch the old technology, and re-arrange workers
  accordingly.
• 4. Climate or soil changes in a region force a
  whole region to change production practices.

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• 5. A change in political leadership forces a
  bureaucracy to change priorities and focus,
  requiring a re-arrangement of individuals to
  tasks.
• 6. The advent of a foreign competitor draws
  attention to different technology and working
  practices, leading to a cycle of innovation,
  destruction, and potential growth.

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• 7. A government decision to relocate some part of
  the state to another city creates opportunities
  for new shops, transport companies, property
  developers, network providers, etc.

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Modern-day equivalent jargon

• - lean and mean
• - need for flexibility
• - the learning organisation
• - adaptive designs
• - the dynamic economy
• - ability to absorb shocks
• - the changing economy

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Policy implications

• 1. In order for individuals to take
  opportunities there must be something in it for
  them, which means there is a need for property
  rights of innovation and of organisations as a
  whole. Hence patent laws, and business ownership.
  

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.

• 2. The fact that changes are so massive and
  multiple all the time means a large slice of the
  population needs to be on the look-out' for
  opportunities. It is in this respect that a
  dictatorship or a central planning system, where
  only very few can take opportunities, fails.

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.

• 3. The recognition of opportunities needs as
  much useful information as possible. Information
  can come from public sources, such as is often
  the case with new technologies made public by
  universities, new laws advertised by the state,
  and likely future changes in the overall
  environment advertised by scientists.

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.

• Social networks and market institutions can
  however also be understood as information
  providers. School diplomas for instance signal
  the ability of the school leaver. Quality control
  institutes for food, machinery, and the like,
  provide information about products to their
  purchasers. Banks can be understood as sifting
  information about suitable moneylenders.

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.

• Personal contacts, friendships, and even outright
  gossip provide exchanges of information about the
  business and work opportunities around
  individuals. Indeed, in many organisations the
  tea room is the place where one truly learns
  about what to do and what not to do what works
  and what doesn't who's in a good mood amenable
  to a suggestion and who is not etc.

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.

• All this information gathering can be seen as
  seeking opportunities in a changing environment.
  Hence, creative destruction brings the world of
  information exchange to the center of economic
  growth.

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.

• 4. The more barriers to changes, the less new
  opportunities can be taken up quickly. One can
  think of many examples here.
• 4a. The more difficult it is to fire someone, the
  harder it is to force someone to do anything
  different or indeed to hire someone else.
• 4b. The harder it is to set up a new business,
  the less new opportunities will be taken up even
  if they are recognised.
• 4c. The harder it is to set up a new plant or to
  re-organise internally, the less lean and mean'
  an organisation can be.

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In conclusion

• The essence of the creative destruction thesis is
  that the more cosy that inert life is, the less
  new opportunities will be sought out and taken.
  Hence live and let die.
• Allowing the old ways to die is a political
  powder keg. The difficulties of restructuring any
  failing industry are there for all to be seen.
  Remember sugar restructuring in Australia last
  year. Watch out for the ocean fishing industry .